Wednesday, January 29, 2014

QE's and the end of the zero lower bound

Here is a graph that is a rough approximation of the date the market expects short term rates to escape the lower bound.

The date stabilized briefly, roughly coincident with QE2.  But generally, over the past 5 years, until the beginning of QE3, that future date, like a carrot on a stick, just kept moving out in the future, with some noise in either direction.

I think we can possibly call Operation Twist a failure.  It apparently didn't do anything to change the trajectory of expecations, but it saddled the Fed with a lot of duration risk that is now a cause of concern for the FOMC and some observers.

Here is a graph of the expected date of the first rate increase and the expected slope of the yield curve at that time:

Source: Authors calculations, based on daily prices of Eurodollars futures
Slope (left scale, in bp), date of first rate hike (right scale, in quarters from 1Q 2013)

The blue line (expected date of the rate hike) corresponds with the QE3 period in the graph above (it is roughly the inverse of that graph).  We can see that all of the permanent increases in interest rates over the past year have been the result of an increase in the slope of the yield curve, not a change in the expected date of the rate increase.

I would expect the slope of the yield curve to slowly trend up to around 40 or 50 bp per quarter, and this would cause a moderate amount of continued increases in interest rates over the next year or so.  (This is the typical slope coming out of a trough.)

I expect the date of the rate increase to arrive in the approximate time frame that the market expects.  The question now is what happens as the Fed tapers.  If some of the tail winds I am seeing in the labor market continue to play out, then we might see that date move up 6 months or so to late 2014.  If the disinflationary pressures of the taper cause the same sort of retardation that the previous QE tapers caused, then rates could crash, and we could have some difficult long-term problems.

The Fed has consistently underestimated the strength of the labor market, and with a current forecast of 6.3% - 6.6% for the 4th quarter of 2014, short of a massive correction in the direction of the economy, they have underestimated it again.  I hope this leads them to a dovish posture.  If that expected date starts creeping out again, we've got some problems.

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